Wednesday, April 27, 2016

Investing in Utility Stocks

Those who read my post from early January, "What's Working in this Market Correction", will know I favor utility stocks in the current market. In fact, the utility ETF, XLU rose from 43 on January 4 to 50 on March 28, or a gain of 16% in 12 weeks. It's since backed off, now trading at 48. I'll explain why in a moment. First, why I like utility stocks and what their performance this year says about the economy.

XLU

Utility stocks essentially trade like bonds. Known for consistent and high dividends, investors buy utility stocks as they would fixed income securities, for their predictable level of dividend payments. The dividend yield, or the relationship between the annual dividend and the stock price, is often equated to a bond yield for more traditional fixed income securities. Utility stocks are not pure dividend plays, though, and we'll get to this issue in a moment, as well.

Trading like bonds, of course, means that price and yield vary inversely. As interest rates rise, the price of bonds and utility stocks decline. As rates decline, utility stocks tend to appreciate. Over the past two months, since the lows of the stock market in February, stocks have rallied following a risk on momentum trade. Bonds have weakened. The US 10-year has traded as low as 1.63% and as high as a 1.97% over this period.

If this risk on rally that has been leading momentum into the least favored sectors of the market is about to turn once again, however, the focus will shift back to the continued weakness in GDP, consumer spending, capital investment, durable goods orders, commodity prices and corporate earnings. This perceived weakness will damage stocks, but boost fixed income securities that rally in the face of low growth and inflation.

This being said, while factors favor utility stocks, I don't prefer the ETF alternatives, and here's why. Utility stocks largely trade like bonds, but not entirely. Their values also swing based upon forecasted revenue on energy sales to their customer base. In some regions of the country, that customer base can be heavily industrial, for instance Texas, Oklahoma and much of the mid-west. If the economy is in fact slowing, industries in these regions will likely reduce their consumption of power, impacting utility revenues.

Residential demand for power, on the other hand, is highly stable and far less impacted by economic cycles. For this reason, better opportunities present themselves in utilities with higher residential customer profiles, than what might be achievable with the XLU. A few large utilities that fit this profile and should be considered are Duke (DUK) with 6.2 million of its total customer base of 7.2 million being residential, Southern (S0) and Exelon (EXC).